The success of the financial industry in navigating the Y2K transition bolstered the public's confidence in technology, remarks David A. Spina, chairman and CEO of State Street Bank (Boston, $87.5 billion in assets). "When we entered into the year 2000 with barely a hitch, the sense of trust in technology was restored -- even strengthened," he said, speaking at TowerGroup's annual conference in Boston on May 20th.
Now it's time to trust technology with a greater role in assuring pension assets and retirement incomes, Spina suggests.
The generational shift from defined-benefit to defined-contribution retirement plans has allowed plan sponsors to manage their financial exposures, and has also permitted a mobile workforce to accumulate retirement assets from several different employers over a modern career. But it's too soon to declare the defined-contribution, employer-match 401(k) retirement plan a success. "Since 401(k) plans have only been in use for about 20 years, it is too early to know precisely how effective they will be," says Spina. "There is enough data to suggest to me that this approach will not produce the level of retirement income our employees expect."
Such unmet expectations, he warns, would lead to "another source of distrust -- distrust of employers and of the financial system as a whole."
To mitigate the potential damage, Spina suggests that the industry "re-think the entire intellectual theory and rationale of pension investing."
For starters, the concept of benchmarking against an index measured by assets has caused pension-plan managers to lose sight of their ultimate goal, which is to ensure that a pension plan can meet its liabilities. "The proper benchmark should be the return required by the nature of these liabilities, including their time horizon," says Spina. "Instead of trying to establish a strategic benchmark, you need to form a strategic policy that states in advance what you will do as both your wealth and market risk premia shift."
Adopting a "liability benchmarking" framework would require pension funds to "articulate their risk preferences at different levels of surplus -- or wealth -- and at different levels of expected reward," says Spina.
The precise and exhaustive description of such preferences across a range of scenarios is known as an investor's "utility function," which, Spina notes, would require substantial help from financially savvy consultants and fund managers in order to implement. What's more, there's a substantial IT component involved in establishing systems to measure investors' utility functions so as to guide fund management.
Furthermore, keeping track of fund managers' performance would also pose an IT challenge. "No longer can you just take a look to see if the manager has matched or beaten an asset-based benchmark," says Spina. "Instead, you first need to see if indeed the manager complied with the risk preferences given their actual level of wealth and given the actual level of expected returns."
"Once you are satisfied that the manager has employed an appropriate 'risk budget,' you will need to see if they employed that risk budget well," he adds.
While more complex than existing practices, the "liability benchmarking" approach has the benefit of using more realistic assumptions than today's asset-liability modeling framework, Spina notes. "Our industry will be challenged to deliver this, but the best funds, consultants and fund managers are already moving in this direction, albeit slowly and carefully," he says.
In addition to better alignment between investors and fund managers, Spina also suggests that the industry develop performance guarantees for individual retirement funds. Given the volatile investment environment, investors may be willing to trade potential upside in return for limited downside on their retirement portfolios. "On that basis, people would find it much easier to make plans," says Spina. "It would require careful collaboration, but it would be pretty popular with the investing public."